Fed Changing Stripes – Political and Historical View
We all know the global economic growth environment has become cloudier. We’ve consistently called for economic growth to decelerate this year. The deceleration in growth appears to be now occurring. In fact, the Federal Reserve is suggesting that monetary policy is going to become more accommodative than has been the case for the last two years.
To prove how slow overall economic growth is becoming, consider the following data points:
- Citigroup economic “surprise” index is now at -30 percent, suggesting continuing economic weakness in relation to expectation. This index hit a low of -50 percent a couple of months ago.
- Global PMI indexes, is at 49.8 (manufacturing), signaling a flattening in manufacturing activity on a global scale. Services PMI is still positive at 52.7, down from 53.7 a month ago.1
- Drilling down into the global PMI data shows all major economic areas outside the United States are experiencing some level of manufacturing contraction. Current index levels1 (as of 6/4/19):
- China: 49.4 vs. 50.1 a month ago.
- Europe: 47.7 vs. 47.9 a month ago.
- Japan: 49.8 vs. 50.2 a month ago.
- It’s important to understand that most geographic area’s services PMI indexes remain in positive territory, suggesting that the global macro weakening is occurring primarily in the manufacturing area, which reflects global impacts of trade policies.
- CEO sentiment appears to be contracting. The survey of CEO sentiment is a good proxy for changes in upcoming capital spending by large corporations. The CEO Confidence Index has contracted by 20 points over the last year, the strongest deterioration we’ve seen in this index for almost two decades.
- Over that 20-year period, there has been a strong (0.72) correlation between CEO confidence and “real” equipment spending levels. Spending on equipment has recently contracted from a 10 percent annual rate to 4 percent.2
Consumer confidence in the United States remains positively elevated. At a reading of 121, it appears consumer’s attitudes towards the economy is reasonably strong but contracting. Also noteworthy…the latest confidence read is the lowest we’ve seen since September 20171.
So, what do the gross domestic product (GDP) numbers tell us? Following is the reported Q1 GDP growth for major economic areas, as compared to overall growth in 2018:
Our bottom line: Foreign economies are starting to show weakening growth (mainly in China and Europe). Large U.S. businesses are apparently becoming cautious. Small business sentiment is still strong but seems to be weakening. It appears the last of the Mohicans is the stalwart U.S. consumer. But as earlier stated, consumer confidence is starting to crack and the announcement in June of a meek 75,000+ jobs added during the month of May did not help.
With the background outlined above, the conversation now shifts to the economic cycle and the national election next year. If, as the year progresses, we see weakening growth in the United States, we will continue to hear more talk of the “R” word…recession. Over the next 30 days, our current expansion will record the longest period of growth in our nation’s history.3 We’ve highlighted times in the past where we believed we were in the later stages of the current expansion, the “boom” phase if you will. Many of the more respected analysts are now coming to the same view – that the cycle is showing definitive signs of maturity and the risk of recession happening over the next 12-18 months is rising.
Some more astute than I believe Trump will only be re-elected if the United States stays out of a recession. Jobs are plentiful. Interest rates are low. Incomes are rising. All of this adds up to a president who could be hard for the Democrats to unseat – unless the economy cracks. If this happens, Trump’s talking points could diminish.
Enter the Fed and Trade Policy
The Fed’s monetary and administrative trade policies are the only two governmental mechanisms for Trump to rest upon as a means to help keep the economy out of recession. This explains why Trump has been leaning on the Fed to reduce interest rates.
From a timing perspective, we can probably assume the Fed will not conduct policies deemed as politically influenced six months prior to the election; they prize their objectivity. Due to market lags, interest rate changes won’t have full effect on final demand and economic momentum for 6-9 months following rate changes. With this in mind, Trump probably knows there is a reasonably narrow window during which the Fed can reduce interest rates to positively effect overall economic activity prior to the election. From a rough timing standpoint, this window appears to be the next 6-9 months.
We are suggesting that political pressure from the Trump administration will do nothing but build against the Fed in an attempt to convince them to lower interest rates starting this summer. Will the Fed acquiesce? It certainly appears to be the case, as economic growth appears to be waning in the United States and globally.
Current Situation – Fed to Reduce Interest Rates
Capital market participants have come to the conclusion that the Fed will initiate an interest rate reduction process next month. The futures market is calling for a 100 percent probability that the Fed is going to reduce rates in July, with the only variable being not if, but by how much.
It was only seven months ago that the Fed raised interest rates and Chairman Powell stated we were a way off from a “neutral” monetary policy. The pivot and reversal of the previous tightening policy, which had been in effect for more than two years, appears to have occurred.
What History Tells Us
The next question to ask, “Will the Fed be successful in delaying or eliminating a recession by lowering interest rates?” We turn to history for answers. Since 1920, there have been 23 examples of initial Fed rate decreases2. What have we learned from these experiences?
- A recession occurred within 12 months following the initial rate decrease on 15 of the 23 observations noted. This suggests that, historically, a recession has occurred within 12 months of the Fed initiating a rate cycle decrease 65 percent of the time.
- Bringing this closer to home, the Fed has initiated a rate decrease cycle on eight previous periods since 1980. The economy was in recession within 12 months following that rate decrease on four of these occasions. However, the economy was in recession within 18 months of the rate decrease five times, representing a recession probability of 63 percent. The times when the Fed initiated a rate decrease cycle when the economy stayed out of recession occurred in 1984, 1995 and 19982,3,4.
- The business cycle was immature in two of the three previous examples of a non-recession rate decrease initiation (1984 and 1995) as the previous recessions had ended two and four years, respectively, prior to the rate decrease.
- The current cycle is now 10 years old, very mature by historical standards.
- We have one example of the last eight (1998) when the Fed initiated a rate reduction cycle when:
- The cycle was rather mature and
- The economy didn’t flow into a recession within the next 18 months
Some would say this time is different and that we shouldn’t use historical experiences to predict what will happen in the future. Of course, every cycle is different than those before. Such is the dynamic nature of market-based economies. Nonetheless, fundamentals of human nature don’t change much over time. Economics is nothing but large group reactions to stimulus. Human emotions of fear and greed don’t change, and typical responses to various stimuli remain unchanged. Consequently, while we can’t fully rely on historical standards of economic events, to be unaware of historical standards is blind.
We have been suggesting that the U.S. economy will stay out of recession this year. We maintain that view. In our opinion, the risk of the economy running into more serious growth problems may intensify in 2020 and onward.
2Ned Davis Research
3National Bureau of Economic Research
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